What Truss’s energy cap means for inflation and your finances

With Liz Truss's energy plans finally announced, Alice Guy explores what the new price cap could mean for inflation, interest rates and your finances.

So, we finally have some good news to write about, as Liz Truss announces today that the energy price will be frozen at £2,500 from October, much lower than the £3,549 bill hike we were expecting.

The collective sigh of relief is almost audible as the new price cap kicks previous forecasts into touch, some as high as £7,000 per year.

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Confusing energy cap

The “energy price cap” is actually a confusing misnomer because it’s nothing like a cap, in the normal sense of the word. You could end up paying a lot more than the much-quoted £2,500 figure as it’s actually based on the energy use for an average 2.4 family in a standard three-bed semi.

Rather than a total price freeze, the cap sets the maximum price per kilowatt hour (kWh) energy companies can charge for gas and electricity, and the actual amount you pay is based on your usage (check this out on your latest energy bill).

The good news is the £2,500 so-called cap doesn’t include the £400 government rebate, so the final price of energy will be £2,100 for the average household this winter: a big difference from the £3,549 bill we were fearing.

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Difference between smaller and larger households

But, there’s a huge gulf between what smaller and larger households will end up paying this winter for their energy.

If you live in a Victorian single-skinned house with an ancient boiler, or bigger detached house, you could end up paying far more for your energy. And if you’re elderly or have a disabled household member, then your bills are also likely to be a lot higher than average.

Our calculation shows that a larger household with a four to five-bedroom home could end up paying around £3,471 per year, £971 above the £2,500 price cap.

Despite the price freeze, we’ll still be paying a higher price for our fuel than last winter. The average household will pay around £36 more per month than last winter even after the £400 energy rebate and larger households could end up paying £76 more per month.

It’s a big hike, and telling your teens to get a move on in the shower won’t be enough to get you bill down to anywhere close to last year’s level.

Why were energy cap predictions so high?

The energy price cap is normally based on how much energy companies pay for their fuel, set on the wholesale gas market. Suppliers buy their energy using forward contracts and are already busy stocking up for January, several months in advance.

And energy geeks like me will have noticed that recent energy cap price predictions vary wildly on an almost daily basis. It’s mainly due to the different time periods analysts use to work out their forecasts.

Tony Jordan, energy analyst from Auxilione, explained to me that their analysis varies daily because it’s based on the forward contracts rate on the energy markets at the end of each day. And during the last few months, that energy price has been bouncing around faster than a balloon at a kids’ party; thus the huge disparity in predictions.

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What the price cap means for inflation?

The newly reduced price cap will pour oil on the waters of consumer inflation and hopefully consign terrifying 20% inflation predictions to the rubbish bin of history.

Those sky-high forecasts were largely driven by soaring energy costs, so cutting the October energy cap will force down inflation in the short term.

Capital Economics predicts that inflation will now peak at “around 11.5% in November and [fall] faster next year. The smaller drag on real incomes means that the recession may be shallower too, perhaps with a peak to trough fall in GDP of around 0.5% rather than 1.0%.”

But medium to long-term inflation could now be higher than expected, as reducing energy costs boosts household disposable income, increasing spending and potentially stoking inflation.

Capital Economics comments that, “by supporting demand, the policy will boost inflation further ahead”.

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Who will pay?

The elephant in the room is who will pay for at least £100 billion of government support, which comes on top of the £300 billion to £400 billion spent getting us through the Covid pandemic.

The final price will depend on interest rates and that other big unknown: future energy prices. And those costs depend in turn on two unpredictable factors: the weather this winter and Vladimir Putin’s actions over the next months and years.

On the plus side, the new PM hopes that reducing energy costs for families and business will prevent a deep recession, bolstering the UK economy and returning more tax into government coffers over the next few years.

Interest rates and markets

For those with cash savings, the energy price freeze could be good and bad news. The price cap will putfurther upwards pressure on inflation, eroding the future value of savings. But that inflation could also lead to higher interest rates as the Bank of England moves to bring down inflation.

Capital Economics comments that, “the risks to our forecast that interest rates will rise from 1.75% now to 3.00% are increasingly on the upside”. And many experts are now predicting interest rates will reach 4% by next spring.

For UK investors, the energy freeze is broadly positive news. The mainly UK-based FTSE 250 has risen 1.75% in the last five days, in contrast to the S&P 500, which fell 0.52% over the same period. The price freeze reduces the risk of a long and deep recession as consumers will have more money to spend over the next two years.

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